Analysts say earnings spark could jolt Europe

SarahTurner

LONDON (MarketWatch) -- The third-quarter earnings season kicks off in Europe on Monday and some in the market are saying that corporate updates could jolt the region's equity market out of its recent range-bound lethargy.

Last week, the Stoxx 600 index (SXXP) wrapped up its best quarterly gain for almost ten years, while the U.K FTSE 100 index (UKX) recorded its best-ever quarterly rise.

That move means that the Stoxx 600 index has gained around 55% since hitting a multi-year low in March.

But the rally stalled a bit at the end of September as investors started to question what could drive stocks higher from this point in an economic environment that remains subdued.

"Focus has fallen on the third-quarter earnings season as the next significant event," said Gerhard Schwarz, equity strategist at UniCredit. "[That] will be the key input factor for the equity markets in the coming weeks," he said.

In July and early August, better-than-expected second-quarter results from companies including German automaker BMW (BMW) helped share prices to rise sharply in Europe.

"A lot of the juice that equity markets have gotten so far this year has been mainly on account of [earnings] exceeding extremely low expectations. Our house view is that will continue to happen this quarter," said Brian Nick, investment strategist at Barclays Wealth.

"I think that a lot of the momentum in the second half of the year can be drawn from the fact that inventories seem to have bottomed," he said.

"Productivity has risen pretty sharply on account of labor costs remaining the same or dwindling. That's always a good environment -- when you are ramping up production with cheap sources of labor -- for corporate profits," he added.

Unemployment is still relatively high around the world and data out last Friday showed unexpectedly weak U.S. nonfarm payroll data.

Still, he's not convinced that there will be the same depth of reaction to cost cutting this time around "because the more you continue to exceed earnings expectations, you've seen net earnings revisions creep up."

"Companies have done a very good job of tearing down their cost bases and we are seeing that expressed in forward-looking estimates," added Phillip Lawlor, a strategist at Nomura Securities.

Analysts expect earnings growth to resume in Europe next year, with companies in the MSCI Europe index on track for 31.1% growth in 2010.

For 2011, they see growth of 23.6% according to data compiled by Morgan Stanley European equity strategists using IBES consensus estimates.

That would compare with an estimated drop of 22.1% for earnings in 2009.

Morgan Stanley analysts, for example, are expecting earnings to fall around 7% quarter-on-quarter for the European oil majors in the third quarter.

"We see good value in the majors, but expect them to tread water as the market recalibrates a tough set of third-quarter numbers," they said. BP (BP)
BP, -0.50%
will be the first major European oil company to report when it releases numbers on Oct. 27.

Analysts took an axe to earnings forecasts at the start of the year when it became obvious that economic growth had fallen off a cliff in the wake of the financial crisis that started mid-2007.

Shares plunged to multi-year lows in March and comparisons with the 1930s depression were rife. However, central bank moves such as ultra-low interest rates, quantitative easing and other monetary policy tools started to restore calm.

"Our 2010 global economic growth forecasts were being sharply downgraded at the start of this year. These downgrades have since reversed everywhere," said portfolio strategists at Citigroup.

"This is both a reflection and a driver of the recovery in equities seen since then," they added.

They added that, although most of the earnings upgrades so far have been driven by better-than-expected cost management so far "we would expect the driver to shift to an improving top-line as economic recovery becomes better established."

At Philips, for instance, which makes everything from coffee machines to magnetic resonance imaging machines, Morgan Stanley analysts said that they expect comparable sales declines to moderate to 14% in the third quarter, from 19% in the second quarter, "driven by growth in some consumer end-markets and easing year-on-year comparatives."

Lawlor at Nomura said that economic growth "is coming in a bit stronger than we thought three or four months ago."

"For every 1% extra on revenue growth, if you keep your fixed costs the same, this can very often transpire into plus 10%-15% earnings growth. The leverage is very substantial," he said.

"We haven't seen it happen yet but we're on cusp and that's what the market is really focused on. If we get that, then the market will be very encouraged," he said.

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